How a credit run affects asset correlation

Christopher Paulus Imanto

Abstract

This paper analyzes the effect of soaring demand in the lending market shortly before a financial crisis (hereafter, a “credit run”). A credit run affects asset correlation, which is one of the main parameters in the internal ratings-based (IRB) approach of the Basel III framework. In the framework, these coefficients are predetermined, and they have not been recalibrated since their introduction in the Basel II Accord. This paper not only questions the assumption of a constant asset correlation, which is a fundamental part of the theoretical foundation of the IRB approach, but also uses a new approach to show that a credit run increases the asset correlation value. Thereby, this paper offers evidence that the asset correlations given in the IRB approach are underestimated. In contrast to other asset correlation studies, this paper provides a new approach that is compatible with the foundation of the IRB approach. Assuming asset correlations are calibrated correctly in the IRB approach, a 2% downturn add-on may be adequate.